A capital lease is a lease that is usually non-cancellable, and is similar to a loan agreement for the purchase of an asset that is to be repaid in installments. The lessor simply finances the asset and the lessee pays all the other costs that are associated with the asset. That would mean insurance, maintenance of the property or asset and taxes. Capital leases are very similar to and are nearly equivalent to a sale. However, the difference is that the lessor keeps the title.
Leased assets must be capitalized and must be distinguished on the lessee’s balance sheet as a fixed asset with a corresponding lease payable and details of the risks of ownership. The lessee is able to claim the interest portion of the payment as an expense.
In order to be considered a capital lease, there are certain criteria that need to be met:
- The title of the asset must pass from the lessor to the lessee at the end of the lease term.
- The lease must contain a bargain purchase option where the lessee may purchase the leased-asset at less than its fair market value.
- The lease term must be longer than a period of 75% of the estimated economic life of the asset.
- The present value of the lease payments is more than 90% of the fair market value of the asset at the start of the lease term.